Elucidate the role of capital account convertibility in controlling deficit in the current account of India's Balance of Payments (BOPs).
Capital account convertibility (CAC) is when there are no restrictions in import and export of capital (debt, equity and other investments) to and from a country.
-India faces a persistent deficit in BOP Current Account (CAD) making it a net importer of capital
-Rupee is convertible on the current account but many restrictions apply on capital transactions (mostly on borrowing from abroad)
Role of CACin controlling CAD
If CAC is allowed:
o Capital inflows will increase in the economy
o Thus the rupee will appreciate
o In the short run since importsare more inelastic to exchange rate changes, CAD improves because foreign imports become cheaper
o Eventually, fall in rupee value of imports will lead to more imports
o Exports become less competitive in world markets and hence decline
o Thus CAD will deteriorate eventually as CAC is permitted and the rupee appreciates from more foreign inflows
-However if capital starved enterprises get access to cheap credit and equity from foreign institutions, their competitiveness might improve. Thus exports increase and CAD improves.
-A boost in debt domestically might also increase domestic output (since bank lending is low in India –only 50% of GDP) which spurs imports (oil etc.) as demand rises.
CAC might worsen the CAD by downward pressure on $-rupee exchange rate. However it mightboost competitiveness of few capital starved firms prompting them to import and export more,having an ambiguous impact on CAD.
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